Endogenous Growth Model

T H E O R I E S O F G R O W T H A N D D E V E L O P M E N T

Endogenous Growth Model 1

PREFACE

The business world is very dynamic. What is best for today is worst tomorrow. So, the modern business students need to change and update them according to the current market conditions.

Various universities and business schools are arranging various modern programs that allow the learners to become more useful and best in the job market. Presentation is one of them and considered as better than anything else. Thanks to our honorable teacher ‘Mr. Anupam Das Gupta’ for arranging such a great opportunity for us to present us on behalf of the class.

While preparing the presentation and the report, we have tried heart and soul to remove all the mistakes possible. But nobody is free from mistakes as well as we are. If any mistake is found, we pray forgiveness.

This document can be used for further reference to the students of economics. We will be glad to share this document in digital version if anybody needs it. Please feel free to send an e-mail by informing any mistakes or the request to find the digital version of this report.

……………………………..

Asadul Hoque (President, 12 Knights) E-mail: [email protected] Web-site: http://aleaf.uuuq.com/12knights.html



WHO WERE BEYOND THIS?

Name ID No. Position

Mohammad Asadul Hoque Lokman 07303112 President

Md. Ashiqur Rahman 07303128 Vice-President

Atiqur Rahaman 07303083 Knight

Md Abu Bakkar Siddik 07303026 Knight

Asiful Hakim 07303025 Knight

Sharmin Tasmin Lucky 07303021 Knight

Mohammad Sohag Howlader 07303037 Knight

Md Ashique Rubaet 07303090 Knight

Md Ashraf Hussain Shakil 07303038 Knight

Anwar Hussain Mamun 07303086 Knight

Chowdhury Mohammad Ariful Mostafa 07303041 Knight

Mohammad Selim Jahan 06303131 Knight



TABLE OF CONTENTS

PREFACE ...................................................................................................................................................................1

WHO WERE BEYOND THIS? ..................................................................................................................................2

TABLE OF CONTENTS ............................................................................................................................................3

PART ONE: INTRODUCTION .................................................................................................................................4

Development Economics.......................................................................................................................................4 Growth and growth rate .......................................................................................................................................5 Growth vs. development .......................................................................................................................................6

PART TWO: THEORIES OF GROWTH..................................................................................................................7

Harrod-Domar Model ..........................................................................................................................................7 Neo-classical Model.............................................................................................................................................8

PART THREE: ENDOGENOUS GROWTH THEORY .........................................................................................10

Main theme ........................................................................................................................................................11 ‘Endogenous theory’ or ‘the new growth theory’: the modern way of sustainable long-run growth ......................12 Assumptions of Endogenous Growth Theory .......................................................................................................12 The theory explanation .......................................................................................................................................13 How this theory is better than others?.................................................................................................................15 Drawbacks.........................................................................................................................................................15

REFERENCES..........................................................................................................................................................17



PART ONE: INTRODUCTION

s people throughout the world awake each morning to face a new day, they do so under very different circumstances. Some live in comfortable homes with many rooms. They have more than enough to eat, are well clothed and

healthy, and a reasonable degree of financial security.

Others, i.e. 3/4th of world’s population or six billion people, are much less fortunate. They may have little or no shelter and an inadequate food supply. Their health is poor, they often can not read or write, they are often unemployed, and their prospects for a better life are uncertain at best.

This scenario is not new. Since the beginning of human civilization, the wall between rich and poor exists. Various economists have developed various theories over the economic development and growth to explain the reasons behind them and to solve various economic problems of human being.

DEVELOPMENT ECONOMICS

Why these problems or big differences are happening?

Development Economics comes forward to explain it and it helps to find out the solution.

A



Development economics is the study of fulfilling unlimited human wants by best utilization of scarce resources and it emphasizes over the infrastructural development as well. It involves the creation of theories and methods that aid in the determination of policies and practices and can be implemented at either the domestic or international level.

“Development Economics is a branch of economics which deals with economic aspects of the development process in low income countries. Its focus is not only on methods of promoting economics growth and structural change but also on improving the potential for the mass of the population, through health and education and workplace conditions, whether through public or private channels. Development economics involves the creation of theories and methods that aid in the determination of policies and practices and can be implemented at either the domestic or international level.”1

GROWTH AND GROWTH RATE

Increasing gross national product of a country in a particular time usually one year is known as the growth. In an economy, national income increases if production increases in one or more sectors. This increase of the national income is generally considered as growth.

1 www.wikipedia.org



Growth rate equation2:

1000

01 ×−

=y

yyGrowth

Where,

y1 = Gross National Product of the current year

y0 = Gross National Product of the previous year

GROWTH VS. DEVELOPMENT

Though many of us think that the term ‘growth’ and ‘development’ are same, but they are not. They have some significant differences between them. They are:

1. Increasing the production in one or more sectors of a country is known as growth. On the other hand, economic development is long-tern process, by which national income of a country increases continuously along with infrastructural development like education, health, communication, transportation, engineering and technology etc.

2. If there is a growth in a country, there may not be any development. But if there is any development there must be an economic growth though development is sometimes considered as the prerequisite of growth.

2 Macro Economics by Dr. Mohammad Liakot Ali Khan, 1st Edition, page no.- 594



PART TWO: THEORIES OF GROWTH

rowth indicated increase in production and national income. Various variables are related with the national income growth. For example: if growth rate increases, then production, employment, investment,

consumption increases and vice versa.

Keeping in a stable and expected position of various economic variables is the main concern of today’s economic policy-makers. Therefore, many development theories have been established so far. From those models, classical, neo-classical, Harrod-Domar and Solow-Swan growth models are very popular. But these models are backdated and have very significant limitations.

Before discussing about endogenous theory, we need to understand what others say.

HARROD-DOMAR MODEL

These two economists have presented their views mainly on behalf of the developed countries. The main problems of developed countries are not development rather keeping full employment stable. Therefore, that was the main concern of Harrod-Domar model.

There are various assumptions, theories and approaches that are used to explain the Harrod-Domar model. This is a very interesting model, no doubt; but not free from various limitations. Some of them are:

� The model is based on the economy of developed countries, not developing countries.

� In this model, savings ratio and capital formulation ratio are assumed to be constant. But they fluctuate a lot.

� The theory is based on ‘Laissez Faire’ economy, where there will be no Govt. interference. But in practical, pure Laissez

G

Adam Smith (Classical Economist)



Faire doesn’t exist at all.

� The model is dependent on savings and capital. But there are elements that can influence the economic development. For instance, management, administration, economic infrastructure etc.

� And, the last one, it is not applicable in the developing countries like Bangladesh, India, Sri Lanka and Pakistan.

NEO-CLASSICAL MODEL

By criticizing the Harrod-Domar, economists Robert Solo has developed a new theory that is named as Neo-classical Solo model. Solo describes that Harrod-Domar’s model has been established on the basis of full employment balance which is very risky and unstable. He describes the model as ‘Knife Edge Problem’ where the economy can face a big inflation and as well as stagflation, from where the economy can never return back.

According to Solo, if capital production ratio and capital labor ratio is considered as flexible, the economy will reach into a stable position automatically.3

Just like other models, this is not free from any criticism. They are:

� The contribution is the net investment in the expected growth rate and actual growth rate is not clear in this model.

� This model ignores the important term that what should be the contribution of Govt. in an economy.

� And, the last one, it doesn’t provide any new theory of development. It just solves the problem of Harrod-Domar model.

� This theory emphasizes over technological advancement, but it couldn’t show the exact determinants of the technological progress.

� This theory is based on diminishing marginal return, which only can ensure a steady rate, not a long-run growth in the economy.

3 Macro Economics by Dr. Mohammad Liakot Ali Khan, 1st Edition, page no.- 607

Roy F. Harrod

(1900-1978)



There are various explanations over Harrod-Domar (Classical) and Solow-Swan (Neoclassical) models that can be found in many development economics books. Therefore, ignoring those explanations, we are going to explain our main concern i.e. Endogenous Theory.



PART THREE: ENDOGENOUS GROWTH THEORY

ndogenous means ‘internally derived’ or ‘without any external cause’. As we have discussed earlier, the previous growth and development models are

based on some assumptions that are confusing and these theory can never ensure the long-term sustainable growth for an economy.

In countries on the leading edge of technology, the advance of knowledge is a key determinant of growth. Invention of new technology is much less important for poorer countries, because poorer countries can grow by “borrowing” technology, as well as by investing in physical and human capital. In this part, we shall examine how society’s choices lead to technical progress- the subject called ‘Endogenous Growth Theory’.

Economist Paul Romer and Robert Lucas are responsible for much of the early development of this concept4. The theory was first established in the year, 1980.

Endogenous growth theory attempts to explain growth rates as functions of societal decisions, in particular saving rates.

4 Macro Economics by Rudiger Dornbusch and others, Ninth Edition, page no: 77

E

Robert Lucas Paul Romer



MAIN THEME

The model defines that output and growth depend on the internal variable saving rate. It is the saving rate that is converted into human capital investment (investment for innovating new ideas and methods). It also holds that technological progress is essential for economy’s long-run growth. But the determinant of the technological progress is the saving rate.

Some important definitions

Some important definitions are needed to understand and keep in mind before the main discussion of ‘Endogenous Growth Theory’. They are shortly discussed below:

� Returns to scale5: Diminishing returns and marginal products refer to the response of output to an increase of a single input when all other inputs are held constant.

Sometimes we are interested in the effect of increasing all inputs. For example, what would happen to wheat production if land, labor, water, and other inputs were increased by the same proportion? Or what would happen to the production of tractors if the quantities of labor, computers, robots, steel, and factory space were all doubled? These questions refer to the returns to scale, or the effects of scale increases of inputs on the quantity produced. Three important cases should be distinguished:

Ψ Constant returns to scale denote a case where a change in all inputs leads to a proportional change in output.

5 Economics, Eighteenth Edition, Samuelson and Nordhaus, McGraw Hill Publication, page no: 111-112

For example, if labor, land, capital, and other inputs are doubled, then under constant returns to scale output would also double.

Ψ Increasing returns to scale arise when an increase in all inputs leads to a more than proportional increase in the level of output.

Ψ Decreasing returns to scale occur when a balanced increase of all inputs leads to a less than proportional increase in total output.

� Spillover Effects6: Spillover effects which involve involuntary imposition of costs or benefits. Market transactions involve voluntary exchange in which people exchange goods or services for money. When a firm buys a chicken to make frozen drumsticks, it buys the chicken from its owner in the chicken market, and the seller receives the full value of the hen. When you buy a haircut, the

6 Economics, Eighteenth Edition, Samuelson and Nordhaus, McGraw Hill Publication, page no: 36



barber receives the full value for time, skills, and rent.

But many interactions take place outside markets. While airports produce a lot of noise, they generally do not compensate the people living around the airport for disturbing their peace. On the other hand, some companies which spend heavily on research and development have

positive spillover effects for the rest of society. For example, researchers at AT&T invented the transistor and launched the electronic revolution, but AT&T’s profits increased by only a small fraction of the global social gains. In each case, an activity has helped or hurt people outside the marketplace; that is, there was an economic transaction without and economic payment.

‘ENDOGENOUS THEORY’ OR ‘THE NEW GROWTH THEORY’: THE MODERN WAY OF SUSTAINABLE LONG-RUN GROWTH

In economics, ‘Endogenous Growth Theory’ or ‘New Growth Theory’ was developed in the 1980s as a response to criticism of the ‘Neo-classical Growth Model’. The ‘Endogenous Growth Theory’ holds that policy measures can have an impact on the long-run growth rate of an economy. For example, subsidies on research and development or education increase the growth rate in some ‘Endogenous Growth Models’ by increasing the incentive to innovate.7

‘Neoclassical Growth Theory’ dominated economic thought for three decades because it does a good job of explaining much of what we observe in the world and because it is mathematically elegant. Nonetheless, by the late 1980s dissatisfaction with the theory had arisen on both theoretical and empirical grounds. ‘Neoclassical Growth Theory’ attributes long-run growth to technological progress but leaves unexplained the economic determinants of that technological progress. Empirical8 dissatisfaction developed over the prediction that economic growth and saving rates should be uncorrelated in the steady state. The data make it clear that saving rates and growth are positively correlated across countries.

ASSUMPTIONS OF ENDOGENOUS GROWTH THEORY

� No population growth

� No depreciation

� Technological progress is essential

� Increasing returns to scale

7 Source: www.wikipedia.org

8 Empirical means based on observation or experience rather than theory.

Endogenous Growth

Steady-state output growth determined by

endogenous variables, for example, the saving rate.



This model assumes that investment in education and research will not only have positive effect on the firm or individual who is making the involvement, but also will have on others of the entire economy.

THE THEORY EXPLANATION

The theory states that as the physical investment is subject to depreciation, so it can only ensure a steady growth for a short period, not for a longer period due to diminishing marginal return. If saving is invested into human capital, it will be helpful to obtain a long-run growth.

This theory emphasizes education, knowledge, experience, research and training are the sources of growth, because these things create a process of innovation.

Innovations are of two types:

� Horizontal Innovation

� Vertical Innovation

Horizontal Innovation: This innovation takes the form of developing new varieties of goods through research. This creates a spillover effect over the economy.

How?

When a design is developed by a researcher, all others can see it. And, can more rapidly develop additional designs. Then they can make this design as patent and can sell to the immediate goods sector.9 When immediate goods sector buy this patent, it has a monopoly power on each designs. It gives a monopoly market power to earn a monopoly return. He enjoys these returns until another design is developed. This makes a source of increasing rate of return.

This is the contribution of the ‘Research Sectors’.

Due to the research sectors, diminishing return is ruled out.

Vertical Innovation: This takes the form of improvements in existing products. Innovation does create new product or technologies. This temporary increase in output would increase productivity, generating a more sustain increase in output growth.

So, it has been understandable that the new contribution of knowledge investment is invented by one. But this benefit goes to the whole economy. Further, each new idea makes the new next ideas possible. Therefore, the knowledge can grow

9 Immediate goods sector means a sector which only generates a food for production.



independently. That’s why; the investment in human capital can ensure a long-run growth.

---------------

Contrast the following figure, where we have changed the assumed shape of the production function to show a constant marginal product of capital. The production function, like the parallel saving curve, is now a straight line. Since the saving curve no longer flattens out, saving is everywhere greater than required investment. The higher the saving rate, the bigger the gap of saving above required investment and the faster is growth.

The economy described in the figure can be illustrated with a simple algebraic model leading to endogenous growth. Assume a production function with a constant marginal product of capital and with capital as the only factor. Specifically, let

Y = aK

That is, output is proportional to the capital stock. The marginal product of capital is simply the constant a.

Assume that the saving rate is constant at s and that there is neither population growth nor depreciation of capital. Then all savings go to increase the capital stock.

Accordingly,

saKsYK ==∆

Or,

saKK =∆ /

The growth rate of capital is proportional to the saving rate. Further, since output is proportional to capital, the growth rate of output is:

saYY =∆ /

In this example, the higher the saving rate, the higher the growth rate of output.10

10 Macro Economics by Dornbusch and others, Ninth Edition, page no: 79



HOW THIS THEORY IS BETTER THAN OTHERS?

As we discussed earlier, various economists have been trying to ensure sustainable growth for an economy. That’s why; they built lots of theories of which classical and neo-classical growth model were very popular. But these theories had some considerable limitations for which they couldn’t ensure the growth for a sustainable longer period of time.

On the other hand, the endogenous model or new growth has been established to remove the mistakes and limitations of the previous theories. As it is a modern theory, can ensure for a sustainable growth for a long period of time, therefore, it is the most successful economic growth theory ever made. The later version of this theory has just been the modern reform, but the main theme is still the same.

DRAWBACKS11

As discussed earlier, it is the most successful economic development theory ever built. But still it is not free from the limitations. Some significant limitations of this theory have been provided below:

� It is also based on some traditional neoclassical assumptions that are often inappropriate for lower developing countries economies. For example: it only considered single sector of production (agricultural, industrial).

� It overlooked the influential factors that are applicable or possible in limited sectors only as because of poor infrastructure, inadequate institutional structures, and imperfect capital goods and markets.

11 Economic Development by Todaro and Smith, Eighth Edition, page no: 150



� It is mainly concerned with long-run growth rather than short-run and mid-run.

Though is has some significant limitations, but it is still the best and most useful growth and development theory. It suits well in developed, developing and underdeveloped countries as well.



REFERENCES

Books that have been used to prepare this report and as well as presentation:

� Economics by Samuelson and Nordhaus, Eighteenth Edition

� Economics by Dr. Liakot Ali Khan, 1st Edition

� Macro Economics by Rudiger Dornbusch, Stanley Fischer and Richard Startz, Ninth Edition

� Economic Development by Michael P. Todaro and Stephen C. Smith, Eighth Edition

� The Economics of Development and Planning by M L Jhingan, 36th Revised Edition

The web-sites that have been browsed during the collection of data are:

� http://economics.about.com/cs/economicsglossary/g/endogenous_g.htm

� econ.la.psu.edu/~bickes/endogrow.pdf

� en.wikipedia.org/wiki/Endogenous_growth_theory

� www.econ.umn.edu/~lej/papers/NeoclassicalHandbook.pdf

� info.worldbank.org/etools/docs/library/.../KnowledgeGrowth-PRWP3539.pdf

� info.worldbank.org/etools/docs/library/.../KnowledgeGrowth-PRWP3539.pdf

� faculty.washington.edu/karyiu/confer/sea05/papers/lee_yu.pdf

� arno.unimaas.nl/show.cgi?fid=135

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Endogenous Growth Model